Businesses often fail to take full advantage of tax savings opportunities that are available to them. This article provides a high level overview of one such tax savings opportunity, namely, non-qualified deferred compensation plans.
What is Deferred Compensation?
Deferred compensation generally includes payments earned in a year prior to the year in which the payment is made for services rendered. This involves the performance of services in year 1 in exchange for payment in year 2 or a later year. For example, a business may enter into a contractual agreement with a commissioned salesman that provides that the business does not have to pay the salesman for any sales in year 1 until year 3. This would constitute deferred compensation.
What is Non-Qualified Compensation?
Qualified compensation refers to qualified arrangements. Qualified arrangements include certain qualified plans, such as 401(k) and other retirement plans. There are a number of rules that must be complied with for a plan to be qualified. Many of these rules attempt to prevent business owners from taking advantage of the tax-advantaged compensation arrangements without allowing their employees take advantage of arrangements as well. Non-qualified compensation is a catch-all classification for other types of compensation arrangements that do not satisfy the qualified arrangement rules.
What are the Benefits of Qualified and Non-Qualified Deferred Compensation?
Qualified deferred compensation arrangements allow businesses an immediate tax deduction for payments made in a current year, even though the recipient may not pay tax on the compensation until some later year. As a general rule, businesses prefer to receive tax deductions on the earliest possible date and employees and contractors prefer to pay taxes on the latest possible date. This is why qualified deferred compensation arrangements, from a tax perspective, are often win-win for the payor and payee.
Without the qualified rules, businesses would either have to delay receiving a tax deduction until a later year or the recipient would have to pay income taxes on the compensation sooner. This is generally what happens with non-qualified deferred compensation arrangements.
Why Would a Business Use Non-Qualified Deferred Compensation Arrangements?
Businesses use non-qualified deferred compensation arrangements for a number of reasons. The primary reason is that the business does not want to comply with the qualified plan rules. This often occurs when an employer does not want to allow employees to participate in a qualified plan, but the employer would like to set aside money from the business for himself.
In some cases, if the employer were to take money out of the business outside of a non-qualified deferred compensation arrangement, the employer may have to report the compensation on his personal tax return and pay tax on the compensation in year 1. If the employer paid himself using a non-qualified deferred compensation arrangement, he may be able to avoid having to report the compensation on his personal tax return and pay tax on the compensation in year 1. While the business may not be entitled to an immediate tax deduction for the compensation, the delayed payment of personal taxes may be more advantageous to the business owner that receiving taxable compensation in year 1. This is especially true if the business owner beleives that he will be able to pay tax on the compensation at a time when the business owner is subject to a lower tax bracket. Business owners may expect to be in a lower tax bracket during the first few years of their retirement, as they might not have other taxable income.
What is this About IRS Audits for Non-Qualified Deferred Compensation?
In 2004, in response to perceived abuses, Congress enacted Code Sec. 409A. This Code section prevents taxpayers from deferring income from many types of non-qualified deferred compensation arrangements beyond the year in which the compensation is earned. The Code provides a number of allowances and exceptions to this rule. It also provides a new 20 percent penalty if the taxpayers fail to comply with these new rules. The IRS has yet to fully implement Code Sec. 409A. The IRS has yet to start auditing taxpayer compliance with Code Sec. 409A either, although it has announced its intention to do so soon. Taxpayers should use this period before the IRS audits start, to have their non-qualified deferred compensation plans reviewed by a qualified tax attorney.